Market Commentary and Fund Performance

Fund Performance Review

In January, the Fund gained 6.24% (HJPIX), slightly outperforming its benchmark, the Russell/Nomura Total Market™ Index with dividends, which rose by 6.12%.

The month’s positive performers among the Global Industry Classification Standard (GICS) sectors included shares of Consumer Discretionary, Industrials, and Information Technology, while there were no sectors that detracted from the Fund’s performance.

Click here for full, standardized Fund performance.

Among the best performers were our investments in Sony Group Corporation, a diversified consumer and professional electronics, gaming, entertainment and financial services conglomerate, Seven & i Holdings Co., Ltd., a Japanese diversified retail group and operator of 7-Eleven convenience stores, and Keyence Corporation, the supplier of factory automation related sensors.

As for the laggards, Tokio Marine Holdings, Inc., the general insurance company with the best underwriting track record in Japan, Santen Pharmaceutical Co., Ltd., a pharmaceutical company specializing in ophthalmology, and Sompo Holdings, Inc., one of the three largest general insurance company in Japan, detracted the Fund’s performance.

This month, Seven & i Holdings announced its earnings results for Q3 of this fiscal year ending February 2023 with revenues of JPY 8.82tn ($66bn) (+43% YoY) and operating profit of JPY 394bn ($2.95bn) (+30% YoY). The large increase in sales and profit is attributable to the contribution of Speedway, the U.S. convenience store and gas station chain acquired by the company recently.

The company is Japan’s largest retail group, which includes the 7-Eleven convenience store chain. In the current fiscal year, the company’s operating income is expected to come in at around JPY 500bn ($3.74bn), of which a little over half will be generated by 7-Eleven operations in the U.S. Its market cap stands at over JPY 5tn ($37bn).

The convenience store business is considered attractive as it is cash flow generative, moderately recession resistant, and has a strong moat with tens of thousands of small physical stores selling daily necessities. The skeptics cite the threat of online e-commerce as the long-term risk but physical brick-and-mortar retail business is unlikely to go away completely. People still shop on the go and convenience stores are a perfect place for it.

Seven & i has long been expanding its U.S. presence since 2006, mainly through mergers and acquisitions (M&A). With the Speedway deal, its U.S. store count became by far the largest. The price tag of this transaction was $13.3bn (after taking into account post-acquisition tax benefit and sale and leaseback arrangements for its stores), valuing the target company at 13.7x earnings before interest, taxes, depreciation and amortization (EBITDA). However, with expected synergies of approximately $650 million, the EBITDA multiple effectively drops to 6-7 times. We believe that much of 7-Eleven Japan’s superior merchandising, operational, and logistical expertise can be transferrable to Speedway to improve their operational metrics. As such, we consider this deal to be value-accretive.

In terms of valuation, Seven & i adopts Japanese generally accepted accounting principles (J-GAAP) for its financial disclosures, which means periodic goodwill amortization is mandatory regardless of whether or not there are impairment risks. For this reason, the company’s earnings per share (EPS) before goodwill amortization is more than 40% higher than its reported EPS. As a cash-based thinker, we use EPS estimate before goodwill amortization of JPY 444 ($3.33) to value the stock, which will yield a price to earnings (PE) multiple of 13 times. It is worth noting that the stock has gone through a valuation de-rating over the last 20 years from an average PE of 24.9 times between FY2005 and FY2014.

The company’s return on equity (ROE) has been substandard, however, falling short of 10% for many years and management is well aware of this. Thanks to the Speedway acquisition, its consolidated ROE should reach 10% on a pre-goodwill amortization basis. Going forward, the company should be able to drive up capital efficiency further owing to 1) stable growth at its domestic 7-Eleven business; 2) increased synergies with the U.S. business and potential for more roll-up deals; 3) likely exit of low profit legacy businesses such as department stores and general merchandise stores (GMS).

On the first point, it is common sense that Japan’s convenience store industry is near a saturation point. However, the company has been making efforts to keep growing. Various initiatives include continuous store renovation, improvement of fresh food products and so on. After all, 7-Eleven is widely regarded as the most well-run convenience store chain with the best track record of the three incumbents (7-Eleven, Family Mart, Lawson) in terms of same store sales growth rates as well as per-store daily store sales figures. Furthermore, the company has been expanding online delivery services, where its massive store network should be a key advantage. Furthermore, in the wake of rising inflation in Japan, its private brand business (Seven Premium) is now thriving. As many national brands have been forced to raise their retail prices, relative attractiveness of private brand products in terms of affordability and quality is being enhanced. For example, according to the company, in this year’s top 10 sales volume ranking for the cup noodle category, Seven Premium-branded products dominated top eight spots, sharply up from just three years ago.

In the U.S., according to industry data, there are 150,274 convenience stores nationwide as of December 2020. Before the Speedway acquisition, 7-Eleven was at the top of the list with 9,519 stores (market share 6.3%) and Speedway ranked third with 3,854 stores (market share 2.6%). Now, the two players combined have over 13,000 stores giving them a 9% share, almost double the size of Canada-listed Alimentation Couche-Tard (ranked second with 4.8% share). Better yet, the U.S. market remains highly fragmented. The top 10 chains account for only 20% of the industry even after the Speedway deal. This is in sharp contrast to Japan, where three oligopolistic players control over 90% of the market. We would expect many more years of consolidation and 7-Eleven should be among the main drivers.

In the U.S., convenience stores are typically attached to gasoline stations. As such, in the current fiscal year, the segment’s sales and profits are boosted by higher gasoline prices, which is a cause for concern for next fiscal year as the trend may reverse. We, on the other hand, are of the view that should the gasoline prices soften, then consumers will be tempted to drive more and spend more at convenience stores, which is an offsetting factor. Conversely, there is also the possibility that higher gasoline prices are here to stay. In past cycles, when energy prices rose, it facilitated investments in a new supply of oil, resulting in price moderation. However, due to the de-carbonization trend around the world, new supply is no longer easy to come by, potentially contributing to higher price levels for gasoline (this may accelerate the shift to EVs from ICEVs. To this end, the company has already begun rolling out EV charging stations to meet this demand over the long run).

Another important characteristic of this business is that revenue is determined by the fuel margin (commonly known as CPG or cent-per-gallon). Interestingly, over the last few years, CPG has been on a rising trend. The explanation for this is as follows. The gasoline station industry is fragmented with about 65% of the players being small-scale, single store operators. As inflation has eroded profitability of merchandise sales (CVS part of the business) in recent years, these operators have resorted to higher CPG (determined individually by gasoline station owners and collectively set the industry standards as a whole) to make up for the weak sales. This industry dynamic has been also strengthened by the fact that most oil majors have exited their gas station and convenience store business in order to focus on their core operations, leading to a benign competitive environment since no price war is taking place anymore among these large players. Needless to say, there are unlikely to be any new entrants into this market. Seven & i and other CVS chains are emerging as beneficiaries of this new “norm.” Going forward, even if gasoline prices soften or sales volumes drop, the industry should be able to sustain the current profit level.

On the third point, Seven & i Holdings houses Seibu & Sogo department stores and Ito-Yokado supermarket chain have become obsolete business models in today’s domestic retail landscape. Management has put the department store business up for sale and is now in the process of completing the transaction with private equity firm Fortress Investment Group. Additionally, the company is currently working to draw up a new “Capital Reallocation Plan” under the new management team. Ultimately, capital allocation is of paramount importance for any CEO’s job. With the profits generated each year, how well the profit is allocated determines how much value can be created for the shareholders. If the company has a profitable business with ample addressable market ahead, which can yield higher returns than the cost of capital, then the retained earnings should be reinvested. Alternatively, if there is no such reinvestment opportunity and no other alternatives are available to create shareholders’ value, then it should be returned back to the shareholders through dividends and share buybacks. Of course, share buybacks needs to be considered carefully whether the current share price is substantially lower than what the management conservatively estimates as the fair value of its stock.

Lastly, according to Reuters, it was reported last month that famous U.S. activist fund ValueAct Capital, who has been a shareholder of the company since 2021, has sent a new letter urging management to reorganize the group structure in order to realize full value of its convenience store franchise as a stand-alone business. While it remains to be seen how the management will respond to the proposal, this could be a potential positive development, and if so, current shareholders will likely be rewarded handsomely.

Click here for a full listing of Holdings.